As investors, we like to think that every decision to buy, sell, or hold is deeply rooted in logic and discipline. Unfortunately, that's not always the case.
Investors are inherently vulnerable to biases, or cognitive shortcuts that lead to inaccurate or irrational conclusions. Biases are a part of our nature as humans, and they periodically get in the way of our better judgment. What's more, sometimes we're not even aware we hold them.
However, just because we're prone to biases doesn't mean we have to let them guide our decisions. With some practice, we can learn from our mistakes and shortcomings and try to mitigate their potential moving forward. Following a systematic, rules-based approach to decision-making can help.
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Some of the more common biases that appear regularly in the investing world are confirmation bias, availability bias, and recency bias. These three are notorious for making investors poorer. If we can identify these biases in our investment process, we can try minimize their effects.
1. Confirmation bias
Confirmation bias is the inclination to ignore information that goes against our views, and instead seek out information that -- you guessed it -- confirms our beliefs. Instead of accumulating facts and vetting them for relevancy, we start with a conclusion and search for information to verify its validity.
For example, let's say that you've been an Apple (AAPL 1.93%) shareholder for the last five years. You purchased shares because of Apple's ability to innovate, the company's incessant focus on the consumer, and the belief that iPhone sales will continue to grow. Since the time of your purchase, the company's revenues and earnings-per-share (EPS) have grown nicely, and your position is up big. Moreover, you love the company's new iPhone and feel that Tim Cook will continue to make sage business decisions well into the future. However, the day after earnings are reported, you find a third-party report saying Apple's success is fading, highlighting the fact that iPhone sales are starting to slow as proof. Now comes the hard part.
When new information starts to conflict with your original investment thesis, confirmation bias kicks in. You may try to discount the report you read, saying "It's only temporary," or "This report misunderstands Apple's strategy." After all, the company's stock price is up 140% over the last five years, so management must be doing something right.
Perhaps you're right to keep supporting Apple through this dip. But your affinity for Apple could also be getting in the way of your better judgment -- and that puts you in a bad position to make decisions moving forward.
When new information challenges your original investment thesis, it's best to consult the company's financials, read opinions that are opposed to your own, and be honest about your motivations. This just may help you lessen the effects of confirmation bias.
2. Anchoring bias
The anchoring bias is the likelihood of assigning too much weight to an initial piece of information. Our minds can "anchor" to that information, and it's used as a reference point moving forward, regardless of relevancy.
Let's use the stock price of Microsoft (MSFT 0.73%) to see how anchoring works.
As of December 10, Microsoft's stock trades at a price close to $151 per share. That's an anchor point. However, this doesn't tell us if the stock is cheap or expensive relative to its fundamentals. It's an arbitrary number. That price tells us nothing about Microsoft's business, management, or strategic initiatives. All this figure provides us is a snapshot in time. Still, investors will use that information to make buying and selling decisions.
If Microsoft's price drops precipitously below $151 tomorrow -- for any sort of reason -- some investors may perceive this fall as a sale and a good time to buy, while other investors may see the drop as the start of deeper problems and a good time to sell. Those investors that are anchored to this initial price now will use that price as the basis for decision-making going forward. But remember: that $151 stock price doesn't hold meaning in isolation.
To fight back against the effects of anchoring, make sure you're not a single-metric investor. You could check Microsoft's historical stock prices, for example. This historical comparison can give you a better idea if the stock is trading rich or cheap to its fundamental value.
3. Recency bias
Recency bias occurs when investors put an emphasis on recent events and give less weight to those that have happened in the past. It skews perception toward short-term thinking.
During a bull market, investors' appetite for risk is generally increased as they extrapolate recent gains into the future. Since stocks have been moving higher as of late, investors are more likely to believe that stocks will continue to appreciate in value.
However, the same holds true in the depths of a bear market. Risk appetites dry up as investors flee stocks. The future looks hopeless due to the latest, depressed pricing action.
Recency bias tends to appear in markets through terms such as "momentum" and "trend." If you happen to come across these words in financial media, proceed with caution. And to fight off recency bias in your own portfolio, adhere to a disciplined, long-term investment horizon with specific investment goals.
With all of that under consideration, it's important to note that these biases will vary among individuals. Every investor is unique, and some may be more prone to biases than others. It's important to consult other opinions and employ a rules-based system for investment decision-making. Your wallet will thank you.
